Return To 401(k) & Annuities

Plan Distributions Before Age 59 1/2

Distributions from qualified plans, 403(b) annuities, SIMPLE plans, and all IRAs may be subject to a 10% penalty tax if made prior to the participant reaching age 59 ½. The penalty tax is waived if the distribution is rolled over (to an eligible recipient plan) or if the participant is totally disabled or dies.

Since premature withdrawals are generally also subject to ordinary income tax; this additional penalty could make the total tax very burdensome.

There are several possible exceptions to this penalty rule:

A. For qualified employer plans; 403(b) annuities, and SIMPLE plans for distributions to participants who have separated from employment after age 55.

B. When distributions are for deductible medical expenses or pursuant to a qualified domestic relations order, e.g., a divorce decree.

C. In certain situations, premature distributions from IRAs to pay health insurance premiums for unemployed individuals may also avoid the penalty tax.

D. For IRAs there are two other exceptions:

E. One other exception, which is available to any qualified plan, SIMPLE, TSA (403(b) annuity), or IRA participant is the "substantially equal" payments exception.

Substantially Equal Payments

This exception applies when the distribution is part of a scheduled series of substantially equal payments for the life expectancy of the participant (and when elected, his or her named beneficiary, e.g., spouse, child, etc.). The IRS approves of three different methods of calculating the distribution, IRS notice 89-25, 1989-1 C.B. 662, Q and A i2

A. Single or Joint Life Expectancy: Payments can be spread over the number of years set forth in Table V (for single persons) or Table VI (for joint recipients) found in Treasury Reg. Sec. 1.72-9. This will provide the lowest payment in early years, because a 0% interest factor is used.

B. Amortization Method: The payment under this method would be similar to the annual amount required to pay off a loan (equal to the amount in the plan) at a reasonable interest rate over the number of years of life expectancy; for example, 33.1 years for a person aged 50.

C. Annuity Method: Under this method₇ an annuity factor must be determined from a "reasonable" mortality table at an interest rate which is then reasonable for the age of the recipient of the distribution. The amount in the plan is then divided by this factor to arrive at the amount of the distribution.

The following comparison of methods is based on the assumptions shown:

When terminating or changing employment prior to age 59½, a person often has several options as to what to do with the funds in his or her qualified retirement plan. He or she may:

A. Leave Funds in Current Plan: if the current value exceeds $5,000, there may be some benefit to leaving the funds where they are. They will continue to grow tax-deferred and can be transferred at a later date to a rollover IRA or a new employer's eligible recipient plan.

B. Take Cash in Lump Sum: This option will require the entire amount to be subject to income taxes in the participant's current tax bracket. There will be an additional 10% penalty tax for a participant under age 59½ unless he or she falls under certain exceptions.- The law requires that 20% of the distribution be withheld for Federal Income Taxes.

C. Use Rollover IRA: Persons receiving cash distributions have the option of transferring the funds to a rollover IRA or a new employer⁷s qualified plan within 60 days of receiving the funds. This will continue to defer the taxation of the distribution, However, unless the transfer is made directly to the IRA or employer plan, there is a 20% income tax withholding required.

D. Direct Transfer to Another Qualified Plan: The distribution can be transferred directly from one employer-sponsored qualified plan to another. Since the participant does not actually receive the funds, there is no 20% withholding.

Potential Problem

However; if the plan makes a 20% withholding, which cannot be returned until after the tax returns for that year are filed, the participant may have to come up with additional funds to make a full rollover.

For example, assume a distribution of $100,000 made directly to a terminating employee. The employer would withhold 20%; or $20,000, for income tax purposes, and the employee would receive only $80,000 in cash. If the employee decides within the 60-day period to roll the fund over into an IRA or a new employer's qualified plan, then he or she must come up with another $20,000 to make the full transfer.

If the funds are not found to make the full $100,000 transfer. then the $20,000 withheld becomes taxable to the employee as ordinary income. If the employee is under age 59½ when the distribution is made, a 10% penalty tax may also be due, unless certain exceptions apply

Solution

To avoid this potential problem the participant must make some decisions before the plan administrator prepares the check. If the transfer is made directly to a rollover IRA or a new qualified plan, the 20% withholding is not made and the entire amount can he transferred.

An alternative might be for the participant to transfer the funds to a rollover IRA and then elect to receive substantially equal payments over his or her life expectancy and that of another person; if desired.

10-Year Versus 5-Year Averaging Of Lump-Sum Distributions

Persons who were age 50 or older on January 1, 1986 (born before 1936) have an election as to how a lump-sum distribution from a qualified retirement plan is taxed:

A. 10-year forward averaging using the 1986 tax rates (including consideration of the "zero bracket amount"), or

B. The 5-year forward averaging using the tax rates for the year of distribution.

The calculation of the tax is done apart from other income so that a retiree's current income bracket is not a factor.

The chart below illustrates the Federal income tax due on various hypothetical distributions during 1999.